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The “doom loop” and default incentives

Author

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  • Thaler, Dominik
  • Rojas, Luis E.

Abstract

The “doom loop” or “sovereign-bank nexus” has been a key factor in the European debt crisis, driven by feedback between fiscal sustainability risks and financial stability. This Research Bulletin revisits the doom loop, examining strategic default incentives and the unintended effects of policy interventions. While limiting banks’ exposure to sovereign debt can break the doom loop, it may increase default risks by weakening governments’ repayment incentives. Similarly, measures like the ECB’s Transmission Protection Instrument (TPI) or European Safe Bonds (ESBies) can mitigate the doom loop but might introduce new vulnerabilities, requiring precise calibration. Counterintuitively, allowing banks to increase sovereign bond holdings during crises may stabilise markets by reducing default incentives. These findings underscore the complex trade-offs and the need for nuanced policy design at both national and monetary union levels. JEL Classification: E44, E6, F34

Suggested Citation

  • Thaler, Dominik & Rojas, Luis E., 2024. "The “doom loop” and default incentives," Research Bulletin, European Central Bank, vol. 126.
    • Handle: RePEc:ecb:ecbrbu:2024:0126:
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    References listed on IDEAS

    as
    1. Patrick Bolton & Olivier Jeanne, 2011. "Sovereign Default Risk and Bank Fragility in Financially Integrated Economies," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 59(2), pages 162-194, June.
    2. Markus K. Brunnermeier & Luis Garicano & Philip R. Lane & Marco Pagano & Ricardo Reis & Tano Santos & David Thesmar & Stijn Van Nieuwerburgh & Dimitri Vayanos, 2016. "The Sovereign-Bank Diabolic Loop and ESBies," American Economic Review, American Economic Association, vol. 106(5), pages 508-512, May.
    3. Emmanuel Farhi & Jean Tirole, 2018. "Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 85(3), pages 1781-1823.
    4. Markus K. Brunnermeier & Sam Langfield & Marco Pagano & Ricardo Reis & Stijn Van Nieuwerburgh & Dimitri Vayanos, 2017. "ESBies: safety in the tranches," Economic Policy, CEPR, CESifo, Sciences Po;CES;MSH, vol. 32(90), pages 175-219.
    5. Viral Acharya & Itamar Drechsler & Philipp Schnabl, 2014. "A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk," Journal of Finance, American Finance Association, vol. 69(6), pages 2689-2739, December.
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    More about this item

    Keywords

    Bailout; Doom Loop; ESBies; keyword; Self-fulfilling Crises; Sovereign Default; Transmission Protection Instrument;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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